Firm Fundamentals and the Cross Section of Implied Volatility Shapes

Abstract

We investigate whether firm fundamentals can explain the shape of option implied volatility (IV) curve. Extending Geske's (1997) compound option model, we link firm fundamentals to the prices of equity and equity options, and show how the shape of IV curve can vary across firms with leverage, dividend policy, cost of capital, and so on. Using options of S&P 500 constituent companies, we show further empirically that firm fundamentals are important determinants of the IV curve even after controlling for historical volatility, risk-neutral skewness, kurtosis and systematic risk ratio. Fundamentals not only provide statistically and economically explanatory power on the IV curve, but also help reconcile with some stylized facts and puzzles.